Archives For Mark Lemley

[TOTM: The following is part of a symposium by TOTM guests and authors on the 2020 Vertical Merger Guidelines. The entire series of posts is available here.]

This post is authored by Timothy J. Brennan (Professor, Public Policy and Economics, University of Maryland; former Chief Economist, FCC; former economist, DOJ Antitrust Division).

The DOJ Antitrust Division and the FTC have issued draft proposed Vertical Merger Guidelines (VMGs). These have been long-desired in some quarters, and long-dreaded in others. The controversy remains, although those who long desired them may dread what they got, and vice versa. 

I’ve accepted Geoff’s invitation to offer some short thoughts on this blessedly short draft. I’ll focus on what one might call “pure” vertical mergers, as opposed to those based on concerns regarding potential entry or expansion by a vertically integrated firm into its upstream or downstream market. After looking at what the draft classifies as unilateral effects, I’ll then turn briefly to coordinated effects, burden of proof, and the whether we want to go there at all

A notable omission

It’s useful to think of pure vertical mergers mergers in a reverse direction; that is, not the harms they would create, but the benefits of blocking the merger even if it were harmful. The usual argument against prosecuting such mergers is that one would be left with separate firms charging above-competitive prices at one end or the other — and if they do it at both ends, creating double marginalization. 

In that regard, the draft has a notable omission: a skeptical eye toward mergers when a firm with market power is unable to charge a consequently high price. The usual justification is price regulation of a monopoly. Concern about the harm of vertical integration as a means to evade such regulation was the basis for the divestiture by AT&T of its then-regulated, then-monopoly local telephone companies, the mirror image of blocking a vertical merger. This concern also formed the basis of Federal Energy Regulatory Commission orders (here and here) separating control of regulated electricity transmission lines from ownership of unregulated generation.

More controversially, one could apply this in contexts where pricing is limited by something other than explicit regulation. TOTM has recently featured a debate between Geoff Manne and Dirk Auer on one side and Mark Lemley, Doug Melamed, and Steve Salop regarding the FTC’s case against Qualcomm’s licensing practices, where the issue (I think) is about whether FRAND licensing requirements limit Qualcomm’s ability to extract the full rental value of its patents. Perhaps even more out there, I’ve suggested that transaction costs keeping Google from charging directly for search could justify concern with discrimination in favor of its offerings in other markets, without having to reject a consumer welfare standard and where “free” search could justify rather than impede an antitrust case. Whether non-regulatory restrictions on price should justify vertical concerns is, to say the least, complicated. You’ll see that word often, and I’ll come back to it at the end

Raising rivals’ costs and foreclosure: Why would the merger matter?

The seeming truism of raising rivals’ costs is that to raise someone’s costs, you have to raise the price of an input they use or a complement they need. If a merger (or vertical restraint) extends control over an input or complement, the competitive risk arises because that complement market is being monopolized. Accordingly, enforcers need to ensure they are looking at competition and ease of entry in the market that’s being monopolized, not the market in which the bad guy who benefits might operate. For example, in the case involving Intel’s loyalty rebates to computer makers that allegedly excluded AMD’s processing chips, the relevant market was not chips but computers, and it is necessary to explain why AMD couldn’t get new computer makers to use its chips or vertically integrate itself into computers. 

With a “pure” vertical merger, however, the raising rivals’ cost or foreclosure story depends not on the creation or expansion of market power over an input or complement. It must depend on how vertical integration leads to the exercise of power in that market that was not being exercised before. That requires that vertical integration changes the strategic interactions determining price and quality. 

If this is the story, however, the agencies should make clear that they bear an obligation to explain how vertical integration matters, rather than assume a competitive outcome otherwise. The recent (failed) Justice Department challenge to AT&T’s vertical acquisition of Time Warner programming bears this out. DOJ’s core claim was that post-merger, Time Warner program services (HBO, CNN) would strike tougher deals with other video distributors, leading to higher licensing fees, because they would know that a failed negotiation would increase subscribership to AT&T. However, once a program service licenses to any video distributor, it realizes that if other video distributors don’t take their service, it will increase subscribers and profits from its initial deal. If that change in bargaining position benefits whoever gets the first deal, distributors presumably can cut a deal to be the first, without vertical merger being necessary. 

Might vertical merger still matter? Perhaps, but plaintiffs should have to explain what transaction costs prevent such a nominally anticompetitive deal. Critics of indifference to vertical mergers, and the draft VMGs, point out that double marginalization might be eliminated without vertical integration, through use of contracts that include fixed fees and sales at marginal cost. A similar skepticism regarding the need for vertical integration to achieve anticompetitive ends is similarly appropriate. Establishing that need may be, well, complicated

Coordination and symmetry

I have less to say about coordinated effects. Knowing when firms decide to switch from competing to cooperating is probably a matter of psychology and sociology as much as economics. However, economics does suggest that collusion is more likely the more symmetric are the positions of the potential colluders, to help find a mutually agreeable tactic and reduce the need for side payments and the like. To the extent symmetry is relevant, a pure vertical merger will facilitate collusion only if other market participants were similarly integrated. And absent market-wide collusion to integrate, this integration of the other participants could be reasonably interpreted as evidence of efficiencies of vertical integration. This would make a coordinated effects vertical merger case, well, complicated.

The burden of proof

As part of a widely voiced dissatisfaction with the last few decades of antitrust enforcement, some commentators have suggested that vertical mergers deserve no more of a presumption of being good than horizontal mergers. I would argue that the strength of evidence necessary to block a vertical merger should remain greater than that for horizontal mergers. This is not (just) because mergers between complements are more likely to lead prices to fall — eliminating double marginalization being an example — while horizontal mergers are likely to bring about upward pricing pressure. It is that the behavior that warrants concern with horizontal mergers, joint price setting, is illegal. Thus, the horizontal merger might be the only way to enable that conduct. 

Contracting alternatives to vertical merger abound, as two-part pricing to eliminate double marginalization and sequential per-subscriber pricing in video markets illustrate. Absent regulation, the transaction costs necessary to create and exercise market power but for vertical integration will be lower than those necessary to create and exercise that power but for horizontal merger. This difference in transaction costs means that horizontal merger is more likely to be necessary for harm than vertical merger. Thus, proving that the latter are harmful should be, well, more complicated.

So, are pure vertical mergers worth the trouble to prosecute?

Vertical mergers might be problematic, but cases are necessarily going to be complicated. This raises the question of whether the benefits of prosecuting such mergers are worth the costs, at least outside the regulated industry context. These costs are not just the cost of litigation but the costs to companies of having to hire antitrust counsel and consultants to try to determine whether their merger is likely to be challenged, how much negotiation with the agencies will be entailed, and what the likelihood of loss in court will be. Some aspects of antitrust enforcement, primarily determining who competes with whom and how much, are inevitably complicated. But it is not clear that we are better off expending the resources to see whether something is bad, rather than accepting the cost of error from adopting imperfect rules — even rules that imply strict enforcement. Pure vertical merger may be an example of something that we might just want to leave be.

Qualcomm is currently in the midst of a high-profile antitrust case against the FTC. At the heart of these proceedings lies Qualcomm’s so-called “No License, No Chips” (NLNC) policy, whereby it purportedly refuses to sell chips to OEMs that have not concluded a license agreement covering its underlying intellectual property. According to the FTC and Qualcomm’s opponents, this ultimately thwarts competition in the chipset market.

Against this backdrop, Mark Lemley, Douglas Melamed, and Steven Salop penned a high-profile amicus brief supporting the FTC’s stance. 

We responded to their brief in a Truth on the Market blog post, and this led to a series of blog exchanges between the amici and ourselves. 

This post summarizes these exchanges.

1. Amicus brief supporting the FTC’s stance, and ICLE brief in support of Qualcomm’s position

The starting point of this blog exchange was an Amicus brief written by Mark Lemley, Douglas Melamed, and Steven Salop (“the amici”) , and signed by 40 law and economics scholars. 

The amici made two key normative claims:

  • Qualcomm’s no license, no chips policy is unlawful under well-established antitrust principles: 
    Qualcomm uses the NLNC policy to make it more expensive for OEMs to purchase competitors’ chipsets, and thereby disadvantages rivals and creates artificial barriers to entry and competition in the chipset markets.”
  • Qualcomm’s refusal to license chip-set rivals reinforces the no license, no chips policy and violates the antitrust laws:
    Qualcomm’s refusal to license chipmakers is also unlawful, in part because it bolsters the NLNC policy.16 In addition, Qualcomm’s refusal to license chipmakers increases the costs of using rival chipsets, excludes rivals, and raises barriers to entry even if NLNC is not itself illegal.

It is important to note that ICLE also filed an amicus brief in these proceedings. Contrary to the amici, ICLE’s scholars concluded that Qualcomm’s behavior did not raise any antitrust concerns and was ultimately a matter of contract law and .

2. ICLE response to the Lemley, Melamed and Salop Amicus brief.

We responded to the amici in a first blog post

The post argued that the amici failed to convincingly show that Qualcomm’s NLNC policy was exclusionary. We notably highlighted two important factors.

  • First, Qualcomm could not use its chipset position and NLNC policy to avert the threat of FRAND litigation, thus extracting supracompetitve royalties:
    Qualcomm will be unable to charge a total price that is significantly above the price of rivals’ chips, plus the FRAND rate for its IP (and expected litigation costs).”
  • Second, Qualcomm’s behavior did not appear to fall within standard patterns of strategic behavior:
    The amici attempt to overcome this weakness by implicitly framing their argument in terms of exclusivity, strategic entry deterrence, and tying […]. But none of these arguments totally overcomes the flaw in their reasoning.” 

3. Amici’s counterargument 

The amici wrote a thoughtful response to our post. Their piece rested on two main arguments:

  • The Amici underlined that their theory of anticompetitive harm did not imply any form of profit sacrifice on Qualcomm’s part (in the chip segment):
    Manne and Auer seem to think that the concern with the no license/no chips policy is that it enables inflated patent royalties to subsidize a profit sacrifice in chip sales, as if the issue were predatory pricing in chips.  But there is no such sacrifice.
  • The deleterious effects of Qualcomm’s behavior were merely a function of its NLNC policy and strong chipset position. In conjunction, these two factors deterred OEMs from pursuing FRAND litigation:
    Qualcomm is able to charge more than $2 for the license only because it uses the power of its chip monopoly to coerce the OEMs to give up the option of negotiating in light of the otherwise applicable constraints on the royalties it can charge.

4. ICLE rebuttal

We then responded to the amici with the following points:

  • We agreed that it would be a problem if Qualcomm could prevent OEMs from negotiating license agreements in the shadow of FRAND litigation:
    The critical question is whether there is a realistic threat of litigation to constrain the royalties commanded by Qualcomm (we believe that Lemley et al. agree with us on this point).”
  • However, Qualcomm’s behavior did not preclude OEMs from pursuing this type of strategy:
    We believe the following facts support our assertion:
    OEMs have pursued various litigation strategies in order to obtain lower rates on Qualcomm’s IP. […]
    For the most part, Qualcomm’s threats to cut off chip supplies were just that: threats. […]
    OEMs also wield powerful threats. […]
    Qualcomm’s chipsets might no longer be “must-buys” in the future.”

 5. Amici’s surrebuttal

The amici sent us a final response (reproduced here in full) :

In their original post, Manne and Auer argued that the antitrust argument against Qualcomm’s no license/no chips policy was based on bad economics and bad law.  They now seem to have abandoned that argument and claim instead – contrary to the extensive factual findings of the district court – that, while Qualcomm threatened to cut off chips, it was a paper tiger that OEMs could, and knew they could, ignore.  The implication is that the Ninth Circuit should affirm the district court on the no license/ no chips issue unless it sets aside the court’s fact findings.  That seems like agreement with the position of our amicus brief.

We will not in this post review the huge factual record.  We do note, however, that Manne and Auer cite in support of their factual argument only that 3 industry giants brought and then settled litigation against Qualcomm.  But all 3 brought antitrust litigation; their doing so hardly proves that contract litigation or what Manne and Auer call “holdout” were viable options for anyone, much less for smaller OEMs.  The fact that Qualcomm found it necessary to actually cut off only one OEM – and then it only took the OEM only 7 days to capitulate – certainly does not prove that Qualcomm’s threats lacked credibility.   Notably, Manne and Auer do not claim that any OEMs bought chips from competitors of Qualcomm (although Apple bought some chips from Intel for a short while). No license/no chips appears to have been a successful, coercive policy, not an easily ignored threat.                                                                                                                                              

6. Concluding remarks

First and foremost, we would like to thank the Amici for thoughtfully engaging with us. This is what the law & economics tradition is all about: moving the ball forward by taking part in vigorous, multidisciplinary, debates.

With that said, we do feel compelled to leave readers with two short remarks. 

First, contrary to what the amici claim, we believe that our position has remained the same throughout these debates. 

Second, and more importantly, we think that everyone agrees that the critical question is whether OEMs were prevented from negotiating licenses in the shadow of FRAND litigation. 

We leave it up to Truth on the Market readers to judge which side of this debate is correct.

Last week, we posted a piece on TOTM, criticizing the amicus brief written by Mark Lemley, Douglas Melamed and Steven Salop in the ongoing Qualcomm litigation. The authors prepared a thoughtful response to our piece, which we published today on TOTM. 

In this post, we highlight the points where we agree with the amici (or at least we think so), as well as those where we differ.

Negotiating in the shadow of FRAND litigation

Let us imagine a hypothetical world, where an OEM must source one chipset from Qualcomm (i.e. this segment of the market is non-contestable) and one chipset from either Qualcomm or its  rivals (i.e. this segment is contestable). For both of these chipsets, the OEM must also reach a license agreement with Qualcomm.

We use the same number as the amici: 

  • The OEM has a reserve price of $20 for each chip/license combination. 
  • Rivals can produce chips at a cost of $11. 
  • The hypothetical FRAND benchmark is $2 per chip. 

With these numbers in mind, the critical question is whether there is a realistic threat of litigation to constrain the royalties commanded by Qualcomm (we believe that Lemley et al. agree with us on this point). The following table shows the prices that a hypothetical OEM would be willing to pay in both of these scenarios:

Blue cells are segments where QC can increase its profits if the threat of litigation is removed.

When the threat of litigation is present, Qualcomm obtains a total of $20 for the combination of non-contestable chips and IP. Qualcomm can use its chipset position to evade FRAND and charges the combined monopoly price of $20. At a chipset cost of $11, it would thus make $9 worth of profits. However, it earns only $13 for contestable chips ($2 in profits). This is because competition brings the price of chips down to $11 and Qualcomm does not have a chipset advantage to earn more than the FRAND rate for its IP.

When the threat of litigation is taken off the table, all chipsets effectively become non-contestable. Qualcomm still earns $20 for its previously non-contestable chips. But it can now raise its IP rate above the FRAND benchmark in the previously contestable segment (for example, by charging $10 for the IP). This squeezes its chipset competitors.

If our understanding of the amici’s response is correct, they argue that the combination of Qualcomm’s strong chipset position and its “No License, No Chips” policy (“NLNC”) effectively nullifies the threat of litigation:

Qualcomm is able to charge more than $2 for the license only because it uses the power of its chip monopoly to coerce the OEMs to give up the option of negotiating in light of the otherwise applicable constraints on the royalties it can charge. 

According to the amici, the market thus moves from a state of imperfect competition (where OEMs would pay $33 for two chips and QC’s license) to a world of monopoly (where they pay the full $40).

We beg to differ. 

Our points of disagreement

From an economic standpoint, the critical question is the extent to which Qualcomm’s chipset position and its NLNC policy deter OEMs from obtaining closer-to-FRAND rates.

While the case record is mixed and contains some ambiguities, we think it strongly suggests that Qualcomm’s chipset position and its NLNC policy do not preclude OEMs from using litigation to obtain rates that are close to the FRAND benchmark. There is thus no reason to believe that it can exclude its chipset rivals.

We believe the following facts support our assertion:

  • OEMs have pursued various litigation strategies in order to obtain lower rates on Qualcomm’s IP. As we mentioned in our previous post, this was notably the case for Apple, Samsung and LG. All three companies ultimately reached settlements with Qualcomm (and these settlements were concluded in the shadow of litigation proceedings — indeed, in Apple’s case, on the second day of trial). If anything, this suggests that court proceedings are an integral part of negotiations between Qualcomm and its OEMs.
  • For the most part, Qualcomm’s threats to cut off chip supplies were just that: threats. In any negotiation, parties will try to convince their counterpart that they have a strong outside option. Qualcomm may have done so by posturing that it would not sell chips to OEMs before they concluded a license agreement. 

    However, it seems that only once did Qualcomm apparently follow through with its threats to withhold chips (against Sony). And even then, the supply cutoff lasted only seven days.

    And while many OEMs did take Qualcomm to court in order to obtain more favorable license terms, this never resulted in Qualcomm cutting off their chipset supplies. Other OEMs thus had no reason to believe that litigation would entail disruptions to their chipset supplies.
  • OEMs also wield powerful threats. These include patent holdout, litigation, vertical integration, and purchasing chips from Qualcomm’s rivals. And of course they have aggressively pursued the bringing of this and other litigation around the world by antitrust authorities — even quite possibly manipulating the record to bolster their cases. Here’s how one observer sums up Apple’s activity in this regard:

    “Although we really only managed to get a small glimpse of Qualcomm’s evidence demonstrating the extent of Apple’s coordinated strategy to manipulate the FRAND license rate, that glimpse was particularly enlightening. It demonstrated a decade-long coordinated effort within Apple to systematically engage in what can only fairly be described as manipulation (if not creation of evidence) and classic holdout.

    Qualcomm showed during opening arguments that, dating back to at least 2009, Apple had been laying the foundation for challenging its longstanding relationship with Qualcomm.” (Emphasis added)

    Moreover, the holdout and litigation paths have been strengthened by the eBay case, which significantly reduced the financial risks involved in pursuing a holdout and/or litigation strategy. Given all of this, it is far from obvious that it is Qualcomm who enjoys the stronger bargaining position here.
  • Qualcomm’s chipsets might no longer be “must-buys” in the future. Rivals have gained increasing traction over the past couple of years. And with 5G just around the corner, this momentum could conceivably accelerate. Whether or not one believes that this will ultimately be the case, the trend surely places additional constraints on Qualcomm’s conduct. Aggressive behavior today may spur disgruntled rivals to enter the chipset market or switch suppliers tomorrow.

To summarize, as we understand their response, the delta between supracompetitive and competitive prices is entirely a function of Qualcomm’s ability to charge supra-FRAND prices for its licenses. On this we agree. But, unlike Lemley et al., we do not agree that Qualcomm is in a position to evade its FRAND pledges by using its strong position in the chipset market and its NLNC policy.

Finally, it must be said again: To the extent that that is the problem — the charging of supra-FRAND prices for licenses — the issue is manifestly a contract issue, not an antitrust one. All of the complexity of the case would fall away, and the litigation would be straightforward. But the opponents of Qualcomm’s practices do not really want to ensure that Qualcomm lowers its royalties by this delta; if they did, they would be bringing/supporting FRAND litigation. What the amici and Qualcomm’s contracting partners appear to want is to use antitrust litigation to force Qualcomm to license its technology at even lower rates — to force Qualcomm into a different business model in order to reset the baseline from which FRAND prices are determined (i.e., at the chip level, rather than at the device level). That may be an intelligible business strategy from the perspective of Qualcomm’s competitors, but it certainly isn’t sensible antitrust policy.

Qualcomm is currently in the midst of a high-profile antitrust case against the FTC. At the heart of these proceedings lies Qualcomm’s so-called “No License, No Chips” (NLNC) policy, whereby it purportedly refuses to sell chips to OEMs that have not concluded a license agreement covering its underlying intellectual property. According to the FTC and Qualcomm’s opponents, this ultimately thwarts competition in the chipset market.

But Qualcomm’s critics fail to convincingly explain how NLNC averts competition — a failing that is particularly evident in the short hypothetical put forward in the amicus brief penned by Mark Lemley, Douglas Melamed, and Steven Salop. This blog post responds to their brief. 

The amici’s hypothetical

In order to highlight the most salient features of the case against Qualcomm, the brief’s authors offer the following stylized example:

A hypothetical example can illustrate how Qualcomm’s strategy increases the royalties it is able to charge OEMs. Suppose that the reasonable royalty Qualcomm could charge OEMs if it licensed the patents separately from its chipsets is $2, and that the monopoly price of Qualcomm’s chips is $18 for an all-in monopoly cost to OEMs of $20. Suppose that a new chipmaker entrant is able to manufacture chipsets of comparable quality at a cost of $11 each. In that case, the rival chipmaker entrant could sell its chips to OEMs for slightly more than $11. An OEM’s all-in cost of buying from the new entrant would be slightly above $13 (i.e., the Qualcomm reasonable license royalty of $2 plus the entrant chipmaker’s price of slightly more than $11). This entry into the chipset market would induce price competition for chips. Qualcomm would still be entitled to its patent royalties of $2, but it would no longer be able to charge the monopoly all-in price of $20. The competition would force Qualcomm to reduce its chipset prices from $18 down to something closer to $11 and its all-in price from $20 down to something closer to $13.

Qualcomm’s NLNC policy prevents this competition. To illustrate, suppose instead that Qualcomm implements the NLNC policy, raising its patent royalty to $10 and cutting the chip price to $10. The all-in cost to an OEM that buys Qualcomm chips will be maintained at the monopoly level of $20. But the OEM’s cost of using the rival entrant’s chipsets now will increase to a level above $21 (i.e., the slightly higher than $11 price for the entrant’s chipset plus the $10 royalty that the OEM pays to Qualcomm of $10). Because the cost of using the entrant’s chipsets will exceed Qualcomm’s all-in monopoly price, Qualcomm will face no competitive pressure to reduce its chipset or all-in prices.

A close inspection reveals that this hypothetical is deeply flawed

There appear to be five steps in the amici’s reasoning:

  1. Chips and IP are complementary goods that are bought in fixed proportions. So buyers have a single reserve price for both; 
  2. Because of its FRAND pledges, Qualcomm is unable to directly charge a monopoly price for its IP;
  3. But, according to the amici, Qualcomm can obtain these monopoly profits by keeping competitors out of the chipset market [this would give Qualcomm a chipset monopoly and, theoretically at least, enable it to charge the combined (IP + chips) monopoly price for its chips alone, thus effectively evading its FRAND pledges]; 
  4. To keep rivals out of the chipset market, Qualcomm undercuts them on chip prices and recoups its losses by charging supracompetitive royalty rates on its IP.
  5. This is allegedly made possible by the “No License, No Chips” policy, which forces firms to obtain a license from Qualcomm, even when they purchase chips from rivals.

While points 1 and 3 of the amici’s reasoning are uncontroversial, points 2 and 4 are mutually exclusive. This flaw ultimately undermines their entire argument, notably point 5. 

The contradiction between points 2 and 4 is evident. The amici argue (using hypothetical but representative numbers) that its FRAND pledges should prevent Qualcomm from charging more than $2 in royalties per chip (“the reasonable royalty Qualcomm could charge OEMs if it licensed the patents separately from its chipsets is $2”), and that Qualcomm deters entry in the chip market by charging $10 in royalties per chip sold (“raising its patent royalty to $10 and cutting the chip price to $10”).

But these statements cannot both be true. Qualcomm either can or it cannot charge more than $2 in royalties per chip. 

There is, however, one important exception (discussed below): parties can mutually agree to depart from FRAND pricing. But let us momentarily ignore this limitation, and discuss two baseline scenarios: One where Qualcomm can evade its FRAND pledges and one where it cannot. Comparing these two settings reveals that Qualcomm cannot magically increase its profits by shifting revenue from chips to IP.

For a start, if Qualcomm cannot raise the price of its IP beyond the hypothetical FRAND benchmark ($2, in the amici’s hypo), then it cannot use its standard essential technology to compensate for foregone revenue in the chipset market. Any supracompetitive profits that it earns must thus result from its competitive position in the chipset market.

Conversely, if it can raise its IP revenue above the $2 benchmark, then it does not require a strong chipset position to earn supracompetitive profits. 

It is worth unpacking this second point. If Qualcomm can indeed evade its FRAND pledges and charge royalties of $10 per chip, then it need not exclude chipset rivals to obtain supracompetitive profits. 

Take the amici’s hypothetical numbers and assume further that Qualcomm has the same cost as its chipsets rivals (i.e. $11), and that there are 100 potential buyers with a uniform reserve price of $20 (the reserve price assumed by the amici). 

As the amici point out, Qualcomm can earn the full monopoly profits by charging $10 for IP and $10 for chips. Qualcomm would thus pocket a total of $900 in profits ((10+10-11)*100). What the amici brief fails to acknowledge is that Qualcomm could also earn the exact same profits by staying out of the chipset market. Qualcomm could let its rivals charge $11 per chip (their cost), and demand $9 for its IP. It would thus earn the same $900 of profits (9*100). 

In this hypothetical, the only reason for Qualcomm to enter the chip market is if it is a more efficient chipset producer than its chipset rivals, or if it can out-compete them with better chipsets. For instance, if Qualcomm’s costs are only $10 per chip, Qualcomm could earn a total of $1000 in profits by driving out these rivals ((10+10-10)*100). Or, if it can produce better chips, though at higher cost and price (say, $12 per chip), it could earn the same $1000 in profits ((10+12-12)*100). Both of the situations would benefit purchasers, of course. Conversely, at a higher production cost of $12 per chip, but without any quality improvement, Qualcomm would earn only $800 in profits ((10+10-12)*100) and would thus do better to exit the chipset market.

Let us recap:

  • If Qualcomm can easily evade its FRAND pledges, then it need not enter the chipset market to earn supracompetitive profits; 
  • If it cannot evade these FRAND obligations, then it will be hard-pressed to leverage its IP bottleneck so as to dominate chipsets. 

The upshot is that Qualcomm would need to benefit from exceptional circumstances in order to improperly leverage its FRAND-encumbered IP and impose anticompetitive harm by excluding its rivals in the chipset market

The NLNC policy

According to the amici, that exceptional circumstance is the NLNC policy. In their own words:

The competitive harm is a result of the royalty being higher than it would be absent the NLNC policy.

This is best understood by adding an important caveat to our previous hypothetical: The $2 FRAND benchmark of the amici’s hypothetical is only a fallback option that can be obtained via litigation. Parties are thus free to agree upon a higher rate, for instance $10. This could, notably, be the case if Qualcomm offsetted the IP increase by reducing its chipset price, such that OEMs who purchase both chipsets and IP from Qualcomm were indifferent between contracts with either of the two royalty rates.

At first sight, this caveat may appear to significantly improve the FTC’s case against Qualcomm — it raises the specter of Qualcomm charging predatory prices on its chips and then recouping its losses on IP. But further examination suggests that this is an unlikely scenario.

Though firms may nominally be paying $10 for Qualcomm’s IP and $10 for its chips, there is no escaping the fact that buyers have an outside option in both the IP and chip segments (respectively, litigation to obtain FRAND rates, and buying chips from rivals). As a result, Qualcomm will be unable to charge a total price that is significantly above the price of rivals’ chips, plus the FRAND rate for its IP (and expected litigation costs).

This is where the amici’s hypothetical is most flawed. 

It is one thing to argue that Qualcomm can charge $10 per chipset and $10 per license to firms that purchase all of their chips and IP from it (or, as the amici point out, charge a single price of $20 for the bundle). It is another matter entirely to argue — as the amici do — that Qualcomm can charge $10 for its IP to firms that receive little or no offset in the chip market because they purchase few or no chips from Qualcomm, and who have the option of suing Qualcomm, thus obtaining a license at $2 per chip (if that is, indeed, the maximum FRAND rate). Firms would have to be foolish to ignore this possibility and to acquiesce to contracts at substantially higher rates. 

Indeed, two of the largest and most powerful OEMs — Apple and Samsung — have entered into such contracts with Qualcomm. Given their ability (and, indeed, willingness) to sue for FRAND violations and to produce their own chips or assist other manufacturers in doing so, it is difficult to conclude that they have assented to supracompetitive terms. (The fact that they would prefer even lower rates, and have supported this and other antitrust suits against Qualcomm doesn’t, change this conclusion; it just means they see antitrust as a tool to reduce their costs. And the fact that Apple settled its own FRAND and antitrust suit against Qualcomm (and paid Qualcomm $4.5 billion and entered into a global licensing agreement with it) after just one day of trial further supports this conclusion).

Double counting

The amici attempt to overcome this weakness by implicitly framing their argument in terms of exclusivity, strategic entry deterrence, and tying:

An OEM cannot respond to Qualcomm’s NLNC policy by purchasing chipsets only from a rival chipset manufacturer and obtaining a license at the reasonable royalty level (i.e., $2 in the example). As the district court found, OEMs needed to procure at least some 3G CDMA and 4G LTE chipsets from Qualcomm.

* * *

The surcharge burdens rivals, leads to anticompetitive effects in the chipset markets, deters entry, and impedes follow-on innovation. 

* * *

As an economic matter, Qualcomm’s NLNC policy is analogous to the use of a tying arrangement to maintain monopoly power in the market for the tying product (here, chipsets).

But none of these arguments totally overcomes the flaw in their reasoning. Indeed, as Aldous Huxley once pointed out, “several excuses are always less convincing than one”.

For a start, the amici argue that Qualcomm uses its strong chipset position to force buyers into accepting its supracompetitive IP rates, even in those instances where they purchase chipsets from rivals. 

In making this point, the amici fall prey to the “double counting fallacy” that Robert Bork famously warned about in The Antitrust Paradox: Monopolists cannot simultaneously charge a monopoly price AND purchase exclusivity (or other contractual restrictions) from their buyers/suppliers.

The amici fail to recognize the important sacrifices that Qualcomm would have to make in order for the above strategy to be viable. In simple terms, Qualcomm would have to offset every dollar it charges above the FRAND benchmark in the IP segment with an equivalent price reduction in the chipset segment.

This has important ramifications for the FTC’s case.

Qualcomm would have to charge lower — not higher — IP fees to OEMs who purchased a large share of their chips from third party chipmakers. Otherwise, there would be no carrot to offset its greater-than-FRAND license fees, and these OEMs would have significant incentives to sue (especially in a post-eBay world where the threat of injunctions is reduced if they happen to lose). 

And yet, this is the exact opposite of what the FTC alleged:

Qualcomm sometimes expressly charged higher royalties on phones that used rivals’ chips. And even when it did not, its provision of incentive funds to offset its license fees when OEMs bought its chips effectively resulted in a discriminatory surcharge. (emphasis added)

The infeasibility of alternative explanations

One theoretical workaround would be for Qualcomm to purchase exclusivity from its OEMs, in an attempt to foreclose chipset rivals. 

Once again, Bork’s double counting argument suggests that this would be particularly onerous. By accepting exclusivity-type requirements, OEMs would not only be reducing potential competition in the chipset market, they would also be contributing to an outcome where Qualcomm could evade its FRAND pledges in the IP segment of the market. This is particularly true for pivotal OEMs (such as Apple and Samsung), who may single-handedly affect the market’s long-term trajectory. 

The amici completely overlook this possibility, while the FTC argues that this may explain the rebates that Qulacomm gave to Apple. 

But even if the rebates Qualcomm gave Apple amounted to de facto exclusivity, there are still important objections. Authorities would notably need to prove that Qualcomm could recoup its initial losses (i.e. that the rebate maximized Qualcomm’s long-term profits). If this was not the case, then the rebates may simply be due to either efficiency considerations or Apple’s significant bargaining power (Apple is routinely cited as a potential source of patent holdout; see, e.g., here and here). 

Another alternative would be for Qualcomm to evict its chipset rivals through strategic entry deterrence or limit pricing (see here and here, respectively). But while the economic literature suggests that incumbents may indeed forgo short-term profits in order to deter rivals from entering the market, these theories generally rest on assumptions of imperfect information and/or strategic commitments. Neither of these factors was alleged in the case at hand.

In particular, there is no sense that Qualcomm’s purported decision to shift royalties from chips to IP somehow harms its short-term profits, or that it is merely a strategic device used to deter the entry of rivals. As the amici themselves seem to acknowledge, the pricing structure maximizes Qualcomm’s short term revenue (even ignoring potential efficiency considerations). 

Note that this is not just a matter of economic policy. The case law relating to unilateral conduct infringements — be it Brooke Group, Alcoa, or Aspen Skiing — almost systematically requires some form of profit sacrifice on the part of the monopolist. (For a legal analysis of this issue in the Qualcomm case, see ICLE’s Amicus brief, and yesterday’s blog post on the topic).

The amici are thus left with the argument that Qualcomm could structure its prices differently, so as to maximize the profits of its rivals. Why it would choose to do so, or should indeed be forced to, is a whole other matter.

Finally, the amici refer to the strategic tying literature (here), typically associated with the Microsoft case and the so-called “platform threat”. But this analogy is highly problematic. 

Unlike Microsoft and its Internet Explorer browser, Qualcomm’s IP is de facto — and necessarily — tied to the chips that practice its technology. This is not a bug, it is a feature of the patent system. Qualcomm is entitled to royalties, whether it manufactures chips itself or leaves that task to rival manufacturers. In other words, there is no counterfactual world where OEMs could obtain Qualcomm-based chips without entering into some form of license agreement (whether directly or indirectly) with Qualcomm. The fact that OEMs must acquire a license that covers Qualcomm’s IP — even when they purchase chips from rivals — is part and parcel of the IP system.

In any case, there is little reason to believe that Qualcomm’s decision to license its IP at the OEM level is somehow exclusionary. The gist of the strategic tying literature is that incumbents may use their market power in a primary market to thwart entry in the market for a complementary good (and ultimately prevent rivals from using their newfound position in the complementary market in order to overthrow the incumbent in the primary market; Carlton & Waldman, 2002). But this is not the case here.

Qualcomm does not appear to be using what little power it might have in the IP segment in order to dominate its rivals in the chip market. As has already been explained above, doing so would imply some profit sacrifice in the IP segment in order to encourage OEMs to accept its IP/chipset bundle, rather than rivals’ offerings. This is the exact opposite of what the FTC and amici allege in the case at hand. The facts thus cut against a conjecture of strategic tying.


So where does this leave the amici and their brief? 

Absent further evidence, their conclusion that Qualcomm injured competition is untenable. There is no evidence that Qualcomm’s pricing structure — enacted through the NLNC policy — significantly harmed competition to the detriment of consumers. 

When all is done and dusted, the amici’s brief ultimately amounts to an assertion that Qualcomm should be made to license its intellectual property at a rate that — in their estimation — is closer to the FRAND benchmark. That judgment is a matter of contract law, not antitrust.

Underpinning many policy disputes is a frequently rehearsed conflict of visions: Should we experiment with policies that are likely to lead to superior, but unknown, solutions, or should we should stick to well-worn policies, regardless of how poorly they fit current circumstances? 

This conflict is clearly visible in the debate over whether DOJ should continue to enforce its consent decrees with the major music performing rights organizations (“PROs”), ASCAP and BMI—or terminate them. 

As we note in our recently filed comments with the DOJ, summarized below, the world has moved on since the decrees were put in place in the early twentieth century. Given the changed circumstances, the DOJ should terminate the consent decrees. This would allow entrepreneurs, armed with modern technology, to facilitate a true market for public performance rights.

The consent decrees

In the early days of radio, it was unclear how composers and publishers could effectively monitor and enforce their copyrights. Thousands of radio stations across the nation were playing the songs that tens of thousands of composers had written. Given the state of technology, there was no readily foreseeable way to enable bargaining between the stations and composers for license fees associated with these plays.

In 1914, a group of rights holders established the American Society of Composers Authors and Publishers (ASCAP) as a way to overcome these transactions costs by negotiating with radio stations on behalf of all of its members.

Even though ASCAP’s business was clearly aimed at ensuring that rightsholders’ were appropriately compensated for the use of their works, which logically would have incentivized greater output of licensable works, the nonstandard arrangement it embodied was unacceptable to the antitrust enforcers of the era. Not long after it was created, the Department of Justice began investigating ASCAP for potential antitrust violations.

While the agglomeration of rights under a single entity had obvious benefits for licensors and licensees of musical works, a power struggle nevertheless emerged between ASCAP and radio broadcasters over the terms of those licenses. Eventually this struggle led to the formation of a new PRO, the broadcaster-backed BMI, in 1939. The following year, the DOJ challenged the activities of both PROs in dual criminal antitrust proceedings. The eventual result was a set of consent decrees in 1941 that, with relatively minor modifications over the years, still regulate the music industry.

Enter the Internet

The emergence of new ways to distribute music has, perhaps unsurprisingly, resulted in renewed interest from artists in developing alternative ways to license their material. In 2014, BMI and ASCAP asked the DOJ to modify their consent decrees to permit music publishers partially to withdraw from the PROs, which would have enabled those partially-withdrawing publishers to license their works to digital services under separate agreements (and prohibited the PROs from licensing their works to those same services). However, the DOJ rejected this request and insisted that the consent decree requires “full-work” licenses — a result that would have not only entrenched the status quo, but also erased the competitive differences that currently exist between the PROs. (It might also have created other problems, such as limiting collaborations between artists who currently license through different PROs.)

This episode demonstrates a critical flaw in how the consent decrees currently operate. Imposing full-work license obligations on PROs would have short-circuited the limited market that currently exists, to the detriment of creators, competition among PROs, and, ultimately, consumers. Paradoxically these harms flow directly from a  presumption that administrative officials, seeking to enforce antitrust law — the ultimate aim of which is to promote competition and consumer welfare — can dictate through top-down regulatory intervention market terms better than participants working together. 

If a PRO wants to offer full-work licenses to its licensee-customers, it should be free to do so (including, e.g., by contracting with other PROs in cases where the PRO in question does not own the work outright). These could be a great boon to licensees and the market. But such an innovation would flow from a feedback mechanism in the market, and would be subject to that same feedback mechanism. 

However, for the DOJ as a regulatory overseer to intervene in the market and assert a preference that it deemed superior (but that was clearly not the result of market demand, or subject to market discipline) is fraught with difficulty. And this is the emblematic problem with the consent decrees and the mandated licensing regimes. It allows regulators to imagine that they have both the knowledge and expertise to manage highly complicated markets. But, as Mark Lemley has observed, “[g]one are the days when there was any serious debate about the superiority of a market-based economy over any of its traditional alternatives, from feudalism to communism.” 

It is no knock against the DOJ that it patently does not have either the knowledge or expertise to manage these markets: no one does. That’s the entire point of having markets, which facilitate the transmission and effective utilization of vast amounts of disaggregated information, including subjective preferences, that cannot be known to anyone other than the individual who holds them. When regulators can allow this process to work, they should.

Letting the market move forward

Some advocates of the status quo have recommended that the consent orders remain in place, because 

Without robust competition in the music licensing market, consumers could face higher prices, less choice, and an increase in licensing costs that could render many vibrant public spaces silent. In the absence of a truly competitive market in which PROs compete to attract services and other licensees, the consent decrees must remain in place to prevent ASCAP and BMI from abusing their substantial market power.

This gets to the very heart of the problem with the conflict of visions that undergirds policy debates. Advocating for the status quo in this manner is based on a static view of “markets,” one that is, moreover, rooted in an early twentieth-century conception of the relevant industries. The DOJ froze the licensing market in time with the consent decrees — perhaps justifiably in 1941 given the state of technology and the very high transaction costs involved. But technology and business practices have evolved and are now much more capable of handling the complex, distributed set of transactions necessary to make the performance license market a reality.

Believing that the absence of the consent decrees will force the performance licensing market to collapse into an anticompetitive wasteland reflects a failure of imagination and suggests a fundamental distrust in the power of the market to uncover novel solutions—against the overwhelming evidence to the contrary

Yet, those of a dull and pessimistic mindset need not fear unduly the revocation of the consent decrees. For if evidence emerges that the market participants (including the PROs and whatever other entities emerge) are engaging in anticompetitive practices to the detriment of consumer welfare, the DOJ can sue those entities. The threat of such actions should be sufficient in itself to deter such anticompetitive practices but if it is not, then the sword of antitrust, including potentially the imposition of consent decrees, can once again be wielded. 

Meanwhile, those of us with an optimistic, imaginative mindset, look forward to a time in the near future when entrepreneurs devise innovative and cost-effective solutions to the problem of highly-distributed music licensing. In some respects their job is made easier by the fact that an increasing proportion of music is  streamed via a small number of large companies (Spotify, Pandora, Apple, Amazon, Tencent, YouTube, Tidal, etc.). But it is quite feasible that in the absence of the consent decrees new licensing systems will emerge, using modern database technologies, blockchain and other distributed ledgers, that will enable much more effective usage-based licenses applicable not only to these streaming services but others too. 

We hope the DOJ has the foresight to allow such true competition to enter this market and the strength to believe enough in our institutions that it can permit some uncertainty while entrepreneurs experiment with superior methods of facilitating music licensing.

About a month ago, I was asked by some friends about the shift from the first-to-invent patent system to a first-to-file patent system in the America Invents Act of 2011 (AIA). I was involved briefly in the policy debates in the spring of 2011 leading up to the enactment of the AIA, and so this query prompted me to share a short essay I wrote in May 2011 on this issue. In this essay, I summarized my historical scholarship I had published up to that point in law journals on the legal definition and protection of patents in the Founding Era and in the early American Republic. I concluded that a shift to a first-to-file patent system contradicted both the constitutional text and the early judicial interpretations of the patent statutes that secured patent rights to first inventors.

This legal issue will likely reach the courts one day. A constitutional challenge a couple years ago was rightly dismissed as not being justiciable, but there may yet be an appropriate case in which an inventor is denied a patent given that he or she lost the race to file first in the Patent Office. So, after sharing my essay with my friends, I thought it valuable to post it again on the Internet, because the website on which it was first published ( slipped into digital oblivion long ago.

I was asked to write this essay in May 2011 by the U.S. Business & Industry Council (USBIC)[1] The USBIC requested my scholarly analysis of the first-to-file provision of the AIA, which was being debated as H.R. 1249 on Capitol Hill at the time, because I had been publishing articles in law journals on the legal definition and protection of patents as property rights in the Founding Era and in the early American Republic (see here and here for two examples). In my essay, I identified the relevant text in the Constitution, which authorizes Congress to secure an exclusive right to “Inventors” in their “Discoveries” (Article 1, Section 8, Clause 8). Based on my academic research, I summarized in my essay the historical Supreme Court and lower federal court decisions, which secured patents to inventors according to the same policy justifications used in common-law cases to justify property rights to first possessors of land. Thus, I concluded that the first-to-file provision in the American Invents Act was unconstitutional, based on well-recognized arguments concerning textual analysis of the Constitution and inferences from original public meaning as reflected in the historical judicial record.

There’s more to my essay, though, than just the substantive legal argument. It also provides an insight into the nature of the legal academic debates going back many years, because at the time Professor Mark Lemley of Stanford Law School compared me to an “Obama-birther” and he called this constitutional and legal argument “fringe science.” Given concerns expressed last year in an open letter co-authored by Professor Lemley and others about inappropriate rhetoric used by academics, among other issues (see here for a news report on this letter), it bears noting for the record that this is a concern that goes back many years.

Here’s the basic story: My essay was published by the USBIC in May 2011 and I was invited to speak in congressional staffer briefings and in other venues in Capitol Hill against the AIA on this issue. At this time, I was the only legal academic writing and speaking on Capitol Hill on this issue in the AIA. In late May, the 21st Century Coalition for Patent Reform, which supported enactment of the AIA, distributed on Capitol Hill a response that it had solicited from Professor Lemley. I no longer possess this response statement that was sent out via email by the 21st Century Coalition, but I do have the response I was asked to write on June 1, 2011 in which I explicitly refer to Professor Lemley’s argument against the first-to-invent position. In response to a law professors’ letter to Congress defending the first-to-file provision in the AIA that was circulated on an IP professors listserv (IPProfs), I sent out on IPProfs on June 11 a draft letter to Congress, calling for signatures from other law professors in support of my argument first presented in my essay (the final version is here). The next day, on June 12, Professor Lemley wrote on Facebook that my constitutional and legal argument made me the same as an “Obama-birther.”[2] Although he didn’t refer directly to me, it was clear that it was directed at me given that this posting by Lemley followed the day after my email to all IP professors asking them to join my letter to Congress, and I also was the only law professor actively writing on this issue and speaking on it on Capitol Hill up until then.

The following year, in a New York Times article on the court challenge to the first-to-file provision, Professor Lemley further characterized this constitutional argument as “the legal equivalent of fringe science.”

Before the spring of 2011, my writings on legal doctrine and policy were published only in law journals, and I had never participated in a policy debate over patent legislation. In my academic articles before this time, I had critiqued Professor Lemley’s incorrect historical claims about whether U.S. patents were considered monopolies or property rights, and they reflected a purely academic tone that one should expect in a law journal article (see here). Before spring 2011, I had never addressed Professor Lemley, nor had he addressed me, about the AIA, other legislation or court cases.

Professor Lemley’s “Obama-birther” attack on me was surprising, and when I replied in the comments to his Facebook post solely on the substantive merits of the issue of policy versus law, Professor Lemley defended his accusation against me. (This is evidenced in the screen shot.)[2] At the time, I was still a relatively junior academic, and this was an object lesson about what a senior academic at a top-five-ranked law school considers acceptable in addressing a much-more junior academic with whom he disagrees. This remark in 2011 was not an outlier either, as Professor Lemley has used similar rhetoric in the ensuing years in addressing academics with whom he disagrees; for instance, a couple years ago, Professor Lemley publicly referred to an academic conference that I and other patent scholars participated in as a “Tea Party convention.”

Of course, legal and constitutional disputes consist of opposing arguments. In court cases and legislative debates, there are colorable legal and policy arguments on both sides of a dispute. Few issues are so irrational that they are not even cognizable as having a supporting argument, such as astrology and conspiracy theories like the birthers or 9-11 truthers. So, I will simply let my essay speak for itself as to whether it makes me the same as an “Obama-birther” and if my argument represents “fringe science.”

More important, if or when a good case arises in which an inventor can rightly claim an identifiable and specific harm as a result of the statutory change created by the AIA, I hope my essay will be of some value.

[1] Full disclosure: The U.S. Business & Industry Council paid me for my time in writing the essay, which I disclosed in the essay itself. Unfortunately, as recently reported by IAM Magazine, other legal academics are not always so forthcoming about their financial and legal connections to companies when publicly commenting on court cases or advocating for enactment of legislation.

[2] This is a link to a screen shot I took last year only because the Facebook post by Professor Lemley recently disappeared after I only quoted the language from it about a month ago when I shared on Facebook my essay with my friends and colleagues.

UPDATE on June 7: I added some more supporting links and some additional information after this was initially published on June 6, 2016.

On July 10 a federal judge ruled that Apple violated antitrust law by conspiring to raise prices of e-books when it negotiated deals with five major publishers. I’ve written on the case and the issues involved in it several times, including here, here, here and here. The most recent of these was titled, “Why I think the government will have a tough time winning the Apple e-books antitrust case.” I’m hedging my bets with the title this time, but it’s fairly clear to me that the court got this case wrong.

The predominant sentiment among pundits following the decision seems to be approval (among authors, however, the response to the suit has been decidedly different). Supporters believe it will lower e-book prices and instigate a shift in the electronic publishing industry toward some more-preferred business model. This sort of reasoning is dangerous and inconsistent with principled, restrained antitrust. Neither the government nor its supporting commentators should use, or applaud the use, of antitrust to impose the government’s (or anyone else’s) preferred business model on industry. And lower prices in the short run, while often an indication of increased competition, are not, by themselves, sufficient to determine that a business model is efficient in the long run.

For example, in a recent article, Mark Lemley is quoted supporting the outcome, noting that it may spur a shift toward his preferred model of electronic publishing:

It also makes no sense that publishers, not authors, capture most of the revenue from e-books, when they do very little of the work. I understand why publishers are reluctant to give up their old business model, but if they want to survive in the digital world, it’s time to make some changes.

As noted, there is no basis for using antitrust enforcement to coerce an industry to shift to a particular distribution of profits simply because “it’s time to make some changes.” Lemley’s characterization of the market’s dynamics is also seriously lacking in economic grounding (and the Authors Guild response to the suit linked above suggests the same). The economics of entrepreneurship has an impressive intellectual pedigree that began with Frank Knight, was further developed by Joseph Schumpeter, Israel Kirzner and Harold Demsetz, among others, and continues to today with its inclusion as a factor of production. (On the development of this tradition and especially Harold Demsetz’s important contribution to it, see here). The implicit claim that publishers’ and authors’ interests (to say nothing of consumers’ interests) are simply at odds, and that the “right” distribution of profits would favor authors over publishers based on the amount of “work” they do is economically baseless. Although it is a common claim, reflecting either idiosyncratic preferences or ignorance about the role of content publishers and distributors in the e-book marketplace and the role of entrepreneurship more generally, it is nonetheless mistaken and has no place in a consumer-welfare-based assessment of the market or antitrust intervention in it.

It’s also utterly unclear how the antitrust suit would do anything to change the relative distribution of profits between publishers and authors. In fact, the availability of direct publishing (offered by both Amazon and Apple) is the most likely disruptor of that dynamic, and authors could only be helped by an increase in competition among platforms—in other words, by Apple’s successful entry into the market.

Apple entered the e-books market as a relatively small upstart battling a dominant incumbent. That it did so by offering publishers (suppliers) attractive terms to deal with its new iBookstore is no different than a new competitor in any industry offering novel products or loss-leader prices to attract customers and build market share. When new entry then induces an industry-wide shift toward the new entrants’ products, prices or business model it’s usually called “competition,” and lauded as the aim of properly functioning markets. The same should be true here.

Despite the court’s claim that

there is overwhelming evidence that the Publisher Defendants joined with each other in a horizontal price-fixing conspiracy,

that evidence is actually extremely weak. What is unclear is why the publishers would need a conspiracy when they rarely compete against each other directly.

The court states that

To protect their then-existing business model, the Publisher Defendants agreed to raise the prices of e-books by taking control of retail pricing.

But despite the use of the antitrust trigger-words, “agreed to raise prices,” this agreement is not remotely clear, and rests entirely on circumstantial evidence (more on this later). None of the evidence suggests actual agreement over price, and none of the evidence demonstrates conclusively any real incentive for the publishers to reach “agreement” at all. In actuality, publishers rarely compete against each other directly (least of all on price); instead, for each individual publisher (and really for each individual title), the most relevant competition for this case is between the e-book version of a particular title and its physical counterpart. In this situation it should matter little to any particular e-book’s sales whether every other e-book in the world is sold at the same price or even a lower price.

While the opinion asserts that each publisher

could also expect to lose substantial sales if they unilaterally raised the prices of their own e-books and none of their competitors followed suit,

it also states that

there is no evidence that the Publisher Defendants have ever competed with each other on price. To the contrary, several of the Publishers’ CEOs explained that they have not competed with each other on that basis.

These statements are difficult to reconcile, but the evidence supports the latter statement, not the former.

The only explanation offered by the court for the publishers’ alleged need for concerted action is an ambiguous claim that Amazon would capitulate in shifting to the agency model only if every publisher pressured it to do so simultaneously. The court claims that

if the Publisher Defendants were going to take control of e-book pricing and move the price point above $9.99, they needed to act collectively; any other course would leave an individual Publisher vulnerable to retaliation from Amazon.

But it’s not clear why this would be so.

On the one hand, if Apple really were the electronic publishing juggernaut implied by this antitrust action, this concern should be minimal: Publishers wouldn’t need Amazon and could simply sell their e-books through Apple’s iBookstore. In this case the threat of even any individual publisher’s “retaliation” against Amazon (decamping to Apple) would suffice to shift relative bargaining power between the publishers and Amazon, and concerted action wouldn’t be necessary. On this theory, the fact that it was only after Apple’s entry that Amazon agreed to shift to the agency model—a fact cited by the court many times to support its conclusions—is utterly unremarkable.

That prices may have shifted as well is equally unremarkable: The agency model puts pricing decisions in publishers’ hands (who, as I’ve previously discussed, have very different incentives than Amazon) where before Amazon had control over prices. Moreover, even when Apple presented evidence that average e-book prices actually fell after its entrance into the market, the court demanded that Apple prove a causal relationship between its entrance and lower overall prices. (Even the DOJ’s own evidence shows, at worst, little change in price, despite its heated claims to the contrary.) But the burden of proof in such cases rests with the government to prove that Apple caused prices to rise, not for Apple to explain why they fell.

On the other hand, if the loss of Amazon as a retail outlet were really so significant for publishers, Apple’s ability to function as the lynchpin of the alleged conspiracy is seriously questionable. While the agency model coupled with the persistence of $9.99 pricing by Amazon would seem to mean reduced revenue for publishers on each book sold through Apple’s store, the relatively trivial number of Apple sales compared with Amazon’s, particularly at the outset, would be of little concern to publishers, and thus to Amazon. In this case it is difficult to believe that publishers would threaten their relationships with Amazon for the sake of preserving the return on their newly negotiated contracts with Apple (and even more difficult to believe that Amazon would capitulate), and the claimed coordinating effects of the MFN provisions is difficult to sustain.

The story with respect to Amazon is questionable for another reason. While the court claims that the publishers’ concern with Amazon’s $9.99 pricing was its effect on physical book sales, it is extremely hard to believe that somehow $12.99 for the electronic version of a $30 (or, often, even more expensive) physical book would be significantly less damaging to physical book sales. Moreover, the evidence put forth by the DOJ and found persuasive by the court all pointed to e-book revenues alone, not physical book sales, as the issue of most concern to publishers (thus, for example, Steve Jobs wrote to HarperCollins’ CEO that it could “[k]eep going with Amazon at $9.99. You will make a bit more money in the short term, but in the medium term Amazon will tell you they will be paying you 70% of $9.99. They have shareholders too.”).

Moreover, as Joshua Gans points out, the agency model that Amazon may have entered into with the publishers would have been particularly unhelpful in ensuring monopoly returns for the publishers (we don’t know the exact terms of their contracts, however, and there are reports from trial that Amazon’s terms were “identical” to Apple’s):

While Apple gave publishers a 70 percent share of book sales and the ability to set their own price, Amazon offered a menu. If you price below $9.99 for a book, Amazon’s share will be 70 percent but if you price above $10, Amazon only returns 35 percent to the publisher. Amazon also charged publishers a delivery fee based on the book’s size (in kb).

Thus publishers could, of course, raise prices to $12.99 in both Apple’s and Amazon’s e-book stores, but, if this effective price cap applied, doing so would result in a significant loss of revenue from Amazon. In other words, the court’s claim—that, having entered into MFNs with Apple, the publishers then had to move Amazon to the agency model to ensure that they didn’t end up being forced by the MFNs to sell books via Apple (on the less-attractive agency terms) at Amazon’s $9.99—is far-fetched. To the extent that raising Amazon’s prices above $10 may have cut royalties almost in half, the MFNs with Apple would be extremely unlikely to have such a powerful effect. But, as noted above, because of the relative sales volumes involved the same dynamic would have applied even under identical terms.

It is true, of course, that Apple cares about price differences between books sold through its iBookstore and the same titles sold through other electronic retailers—and thus it imposed MFN clauses on the publishers. But this is not anticompetitive. In fact, by facilitating Apple’s entry, the MFN clauses plainly increased competition by introducing a new competitor to the industry. What’s more, the terms of Apple’s agreements with the publishers exactly mirrors the terms it uses for apps and music sold through the iTunes store, as well. And as Gordon Crovitz noted:

As this column reported when the case was brought last year, Apple executive Eddy Cue in 2011 turned down my effort to negotiate different terms for apps by news publishers by telling me: “I don’t think you understand. We can’t treat newspapers or magazines any differently than we treat FarmVille.” His point was clear: The 30% revenue-share model is how Apple does business with everyone. It is not, as the government alleges, a scheme Apple concocted to fix prices with book publishers.

Another important error in the case — and, unfortunately, it is one to which Apple’s lawyers acceded—is the treatment of “trade e-books” as the relevant market. For antitrust purposes, there is no generalized e-book (or physical book, for that matter) market. As noted above, the court itself acknowledged that the publishers “have [n]ever competed with each other on price.” The price of Stephen King’s latest novel likely has, at best, a trivial effect on sales of…nearly every other fiction book published, and probably zero effect on sales of non-fiction books.

This is important because the court’s opinion turns on mostly circumstantial evidence of an alleged conspiracy among publishers to raise prices and on the role of concerted action in protecting publishers from being “undercut” by their competitors. But in a world where publishers don’t compete on price (and where the alleged agreement would have reduced the publishers’ revenues in the short run and done little if anything to shore up physical book sales in the long run), it is far-fetched to interpret this evidence as the court does—to infer a conspiracy to raise prices.

Meanwhile, by restricting itself to consideration of competitive effects in the e-book market alone, the court also inappropriately and without commentary dispenses with Apple’s pro-competitive justifications for its conduct. Put simply, Apple contends that its entry into the e-book retail and reader markets was facilitated by its contract terms. But the court ignores these arguments.

On the one hand, it does so because it treats this as a per se case, in which procompetitive effects are irrelevant. But the court’s determination to treat this as a per se case—with its lengthy recitation of relevant legal precedent and only cursory application of precedent to the facts of the case—is suspect. As I have noted before:

What would [justify per se treatment] is if the publishers engaged in concerted action to negotiate these more-favorable terms with other publishers, and what would be problematic for Apple is if its agreement with each publisher facilitated that collusion.

But I don’t see any persuasive evidence that the terms of Apple’s deals with each publisher did any such thing. For MFNs to perform the function alleged by the DOJ it seems to me that the MFNs would have to contribute to the alleged agreement between the publishers, just as the actions of the vertical co-conspirators in Interstate Circuit and Toys-R-Us were alleged to facilitate coordination. But neither the agency agreement itself nor the MFN and price cap terms in the contracts in any way affected the publishers’ incentive to compete with each other. Nor, as noted above, did they require any individual publisher to cause its books to be sold at higher prices through other distributors.

Even if it is true that the publishers participated in a per se illegal horizontal price fixing scheme (and despite the court’s assertion that this is beyond dispute, the evidence is not nearly so clear as the court suggests), Apple’s unique role in that alleged scheme can’t be analyzed in the same fashion. As Leegin notes (and the court in this case quotes), for conduct to merit per se treatment it must “always or almost always tend to restrict competition and decrease output.” But the conduct at issue here—whether somehow coupled with a horizontal price fixing scheme or not—doesn’t meet this standard. The agency model, the MFN terms in the publishers’ contracts with Apple, and the efforts by Apple to secure broad participation by the largest publishers before entering the market are all potentially—if not likely—procompetitive. And output seems to have increased substantially following Apple’s entry into the e-book retail market.

In short, I continue to believe that the facts of this case do not merit per se treatment, and there is a good chance the court’s opinion could be overturned on this ground. For this reason, its rejection of Apple’s procompetitive arguments was inappropriate.

But even in its brief “even under the rule of reason…” analysis, the court improperly rejects Apple’s procompetitive arguments. The court’s consideration of these arguments is basically summed up here:

The pro-competitive effects to which Apple has pointed, including its launch of the iBookstore, the technical novelties of the iPad, and the evolution of digital publishing more generally, are phenomena that are independent of the Agreements and therefore do not demonstrate any pro-competitive effects flowing from the Agreements.

But this is factually inaccurate. Apple has claimed that its entry—and thus at minimum its development and marketing of the iPad as an e-reader and its creation of the iBookstore—were indeed functions of the contract terms and the simultaneous acceptance by the largest publishers of these terms.

The court goes on to assert that, even if the claimed pro-competitive effect was the introduction of competition into the e-book market,

Apple demanded, as a precondition of its entry into the market, that it would not have to compete with Amazon on price. Thus, from the consumer’s perspective — a not unimportant perspective in the field of antitrust — the arrival of the iBookstore brought less price competition and higher prices.

In making this claim the court effectively—and improperly—condemns MFNs to per se illegal status. In doing so the court claims that its opinion’s reach is not so broad:

this Court has not found that any of these [agency agreements, MFN clauses, etc.]…components of Apple’s entry into the market were wrongful, either alone or in combination. What was wrongful was the use of those components to facilitate a conspiracy with the Publisher Defendants”

But the claimed absence of retail price competition that accompanied Apple’s entry is entirely a function of the MFN clauses: Whether at $9.99 or $12.99, the MFN clauses were what ensured that Apple’s and Amazon’s prices would be the same, and disclaimer or not they are swept in to the court’s holding.

This effective condemnation of MFN clauses, while plainly sought by the DOJ, is simply inappropriate as a matter of law. In order to condemn Apple’s conduct under the per se rule, the court relies on the operation of the MFNs in allegedly reducing competition and raising prices to make its case. But that these do not “always or almost always tend to restrict competition and reduce output” is clear. While the DOJ may view such terms otherwise (more on this here and here), courts have not done so, and Leegin’s holding that such vertical restraints are to be assessed under the rule of reason still holds. The court’s use of the per se standard and its refusal to consider Apple’s claimed pro-competitive effects are improper.

Thus I (somewhat more cautiously this time…) suggest that the court’s decision may be overturned on appeal, and I most certainly think it should be. It seems plainly troubling as a matter of economics, and inappropriate as a matter of law.

I have a guest blog posting up on Intellectual Ventures’ blog on why a patent war — or “patent thicket” in scholarly parlance — cannot be defined solely in terms of the number of patents involved in the legal and commercial conflict. 

 Check it out at:

As an aside, this issue is important because I keep hearing from some quarters that historical patent wars, such as the Sewing Machine War of the 1850s, weren’t patent thickets for precisely this reason; that is, relative to the number of patents involved in the “smart phone war” today, there were simply too few patents involved in these earlier legal conflicts for them to be identified as “patent thickets.” 

For instance, Professor Mark Lemley made this point in a comment to my recent blog post, Today’s Software Patents Look a Lot Like Early Pharma Patents.  Although this short blog posting addressed only how software patents and early pharma patents were both accused by famous judges of being too complex or too vague for the courts to handle efficiently, Mark instead decided to make the tangential comment: “Um, except for the part where there were 250,000 pharmaceutical patents covering the same product.”  (This was made on Facebook, and so, sorry, no link.)

Pofessor Michael Risch has a great blog posting on why the oft-repeated claim that there are 250,000 patents covering each smart phone is overblown, especially as this statistic is used in the increasingly overheated rhetoric in today’s policy debates in which many people are treating as settled fact that there is a so-called “software patent problem.”  

But even if Professor Risch is wrong and there are in fact 250,000 patents covering each smart phone, this would still not justify the claim that the number of patents is the primary cause of today’s patent war. 

I often heard this point from my fellow academics when I was researching my article on the Sewing Machine War of the 1850s — that things are somehow different today because there are lots more patents covering the same commercial product — and thus I specifically address this issue in my paper.  In fact, I spent several pages discussing this issue and why the premise “thousands of patents = patent war” is profoundly mistaken. 

Given the prevalence of the “250,000 patents cover each smartphone” and similar claims today, though, I realize that it’s an important enough point to carve out these several pages and reproduce them in a blog posting (so that people don’t have to sift through a 50-page article to find it).

So, as I said, check out my guest blog posting at IV’s blog, and poke around there a bit to learn more about the cool things that IV is doing with the patented innovation that it creates, acquires and licenses.

Our book, Competition Policy and Patent Law Under Uncertainty: Regulating Innovation will be published by Cambridge University Press in July.  The book’s page on the CUP website is here.

I just looked at the site to check on the publication date and I was delighted to see the advance reviews of the book.  They are pretty incredible, and we’re honored to have such impressive scholars, among the very top in our field and among our most significant influences, saying such nice things about the book:

After a century of exponential growth in innovation, we have reached an era of serious doubts about the sustainability of the trend. Manne and Wright have put together a first-rate collection of essays addressing two of the important policy levers – competition law and patent law – that society can pull to stimulate or retard technological progress. Anyone interested in the future of innovation should read it.

Daniel A. Crane, University of Michigan

Here, in one volume, is a collection of papers by outstanding scholars who offer readers insightful new discussions of a wide variety of patent policy problems and puzzles. If you seek fresh, bright thoughts on these matters, this is your source.

Harold Demsetz, University of California, Los Angeles

This volume is an essential compendium of the best current thinking on a range of intersecting subjects – antitrust and patent law, dynamic versus static competition analysis, incentives for innovation, and the importance of humility in the formulation of policies concerning these subjects, about which all but first principles are uncertain and disputed. The essays originate in two conferences organized by the editors, who attracted the leading scholars in their respective fields to make contributions; the result is that rara avis, a contributed volume more valuable even than the sum of its considerable parts.

Douglas H. Ginsburg, Judge, US Court of Appeals, Washington, DC

Competition Policy and Patent Law under Uncertainty is a splendid collection of essays edited by two top scholars of competition policy and intellectual property. The contributions come from many of the world’s leading experts in patent law, competition policy, and industrial economics. This anthology takes on a broad range of topics in a comprehensive and even-handed way, including the political economy of patents, the patent process, and patent law as a system of property rights. It also includes excellent essays on post-issuance patent practices, the types of practices that might be deemed anticompetitive, the appropriate role of antitrust law, and even network effects and some legal history. This volume is a must-read for every serious scholar of patent and antitrust law. I cannot think of another book that offers this broad and rich a view of its subject.

Herbert Hovenkamp, University of Iowa

With these contributors:

Robert Cooter, Richard A. Epstein, Stan J. Liebowitz, Stephen E. Margolis, Daniel F. Spulber, Marco Iansiti, Greg Richards, David Teece, Joshua D. Wright, Keith N. Hylton, Haizhen Lee, Vincenzo Denicolò, Luigi Alberto Franzoni, Mark Lemley, Douglas G. Lichtman, Michael Meurer, Adam Mossoff, Henry Smith, F. Scott Kieff, Anne Layne-Farrar, Gerard Llobet, Jorge Padilla, Damien Geradin and Bruce H. Kobayashi

I would have said the book was self-recommending.  But I’ll take these recommendations any day.

Later this year Josh and I have an edited volume with the above title coming out with Cambridge University Press.  The list of contributors is phenomenal, including:

  • Bob Cooter
  • Vincenzo Denicolo
  • Richard Epstein
  • Luigi Franzoni
  • Damien Geradin
  • Keith Hylton
  • Marco Iansiti
  • Scott Kieff
  • Bruce Kobayashi
  • Haizhen Lee
  • Stan Leibowitz
  • Mark Lemley
  • Doug Lichtman
  • Steve Margolis
  • Mike Meurer
  • Adam Mossoff
  • Greg Richards
  • Greg Sidak
  • Henry Smith
  • Dan Spulber
  • David Teece
  • Josh Wright

Our introductory essay, available here, discusses the papers and lays out some of our thoughts about what we know (or don’t know) about how to encourage innovation through competition and patent laws. As they say, get it while it’s hot!

The abstract for the introduction:

This essay is the introduction to a forthcoming volume entitled, Regulating Innovation: Competition Policy and Patent Law Under Uncertainty (Cambridge U. Press 2009 forthcoming).

In addition to introducing all of the papers in the volume, this essay introduces the organizing themes of the volume. Innovation is critical to economic growth. While it is well understood that legal institutions play an important role in fostering an environment conducive to innovation and its commercialization, much less is known about the optimal design of specific institutions. Regulatory design decisions, and in particular competition policy and intellectual property regimes, can have profoundly positive or negative consequences for economic growth and welfare. However, the ratio of what is known to unknown with respect to the relationship between innovation, competition, and regulatory policy is staggeringly low. In addition to this uncertainty concerning the relationships between regulation, innovation, and economic growth, the process of innovation itself is not well understood.

The regulation of innovation and the optimal design of legal institutions in this environment of uncertainty are two of the most important policy challenges of the 21st century. Any legal regime must attempt to assess the tradeoffs associated with rules that will affect incentives to innovate, allocative efficiency, competition, and freedom of economic actors to commercialize the fruits of their innovative labors and foster economic growth. Unfortunately, as this essay describes, our tools for assessing these tradeoffs are limited.

Any coherent regulatory framework must take account of the low level of empirical knowledge surrounding the complex relationship between regulation – both through competition policy and patent law – and innovation, and the corresponding uncertainty caused by this absence of knowledge. The relationship between regulation and innovation has posed a significant challenge to antitrust economists at least since Schumpeter’s suggestion that dynamic competition would result in “creative destruction,” leading to a competitive process where one monopolist would replace another sequentially as new entrants developed a superior product.

Interfering in this dynamic process for the sake of static efficiency gains is perilous, but, of course, not impossible. But regulators and policy makers must take (more) seriously the condition of fundamental uncertainty in which they act, and the significant costs of their inevitable errors before justifying interventions on grounds of promoting competition or facilitating innovation.

This essay and the chapters in this book, approach this critical set of problems from an economic perspective, relying on the tools of microeconomics, quantitative analysis, and comparative institutional analysis to explore and begin to provide answers to the myriad challenges facing policymakers. The strength of this analysis—often described as the New Institutional Economic approach—is in its recognition that understanding economic performance requires not only economic modeling of narrow behavior, but also an understanding of that behavior in its legal, economic, social, and political institutional context.

The essay includes a table of contents for the book.

Dave Hoffman aptly describes the contours of a lot of the blog debate over Brian Leiter’s citation rankings of law professors by specialty:

Objection: “But you didn’t measure X…”
Leiter: “True. Let a hundred flowers bloom, and do your own data collection!”

I’ve got to say, I’m not sure that I really understand any of the objections to Leiter’s provision of this service. I suspect my initial reaction to the rankings was not unlike many law profs — I perused the rankings to look for scholars in my primary field: antitrust.

Apparently, antitrust scholarship is not as heavily cited as other areas in the business law classification with which antitrust is grouped (corporations, securities, commercial law, and bankruptcy). Interestingly, but perhaps not surprisingly given the breadth of the category, there are not many antitrust types that make the list. But there are a few. A quick look at the rankings in business law and law and economics yields the following folks that I recognize as antitrust scholars (even if it is not their primary field):

  1. Richard Epstein (University of Chicago), 3390 citations
  2. Mark Lemley (Stanford University): 2110 citations, age 41.
  3. William Landes (University of Chicago): 1550 citations, age 68
  4. Herbert Hovenkamp (University of Iowa), 1450 citations
  5. Louis Kaplow (Harvard University): 1370 citations, age 51.
  6. George Priest (Yale University): 870 citations, age 60.

I’m probably missing a few.

Categorizing these folks is obviously a very difficult task. Each of these six has published extensively in a number of other areas (IP, tax, law and economics, etc.) as well as made significant contributions to the antitrust literature. Still, my own sense (based mostly on casual empiricism) is that Professor Hovenkamp should be categorized as an antitrust person as I suspect an overwhelming majority of his citations are in antitrust. This change would make Hovenkamp #3 in Business Law. George Priest (#10 on the L&E list) is another candidate for an “antitrust” representative in the Business Law category. But this is a much closer call than Hovenkamp given Priest’s wide ranging publications across L&E generally and its pretty difficult to quarrel with the L&E category classification.

Besides — if I did have a serious quarrel — I guess I could just make my own antitrust ranking! I don’t. But I’ve decided that I’ll work on an antitrust-specific ranking since I’m curious as to what the top 10-20 in antitrust would look like. I’ve assigned an RA to work on tracking down some citation data and will post them along when we’ve got results. Feel free to email me (or comment) if you have thoughts on what a useful set of antitrust scholarship rankings would look like.

As you may know, this past Friday we (Geoff and Josh) organized the inaugural GMU/Microsoft Conference on the Law and Economics of Innovation. Overall, we were extremely pleased with our first entry in this conference series, The Regulation of Innovation and Economic Growth. We had about 130 register for the conference, including many high level FTC and DOJ officials, academics, and industry representatives. In the end we had about 95 attendees. We also hosted a dinner for about 45 Washington VIPs (several FTC folks, a federal judge, prominent attorneys, representatives from USTR and Commerce, etc.) the evening before at Citronelle. A good time and good conversation were had by all.

The conference started off on the right foot with an opening address from Bob Cooter (Berkeley Law) which pointed to institutional and legal solutions to the “double trust problem” in innovation as a primary factor in unleashing entrepreneurial forces in countries facing high levels of poverty and stagnant growth. The basic point was that various institutions—including importantly IP laws—serve to facilitate the essential melding of ideas and capital necessary to promote innovation and to encourage economic growth. The talk was derived from a book Cooter is currently writing (with Hans-Bernd Schaefer), two draft chapters of which are available here.

The three subsequent panels discussed the innovative process & bundling in technology markets, IP Reform, and Antitrust Regulation of Innovation. The papers are available here. We both took notes on the presentations and share some reflections on the papers and discussions below the fold.

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